Wednesday, February 25, 2009

The Dow closed positive; all Asian markets are up as well. Yesterday, our market recovered from its losses as the government announced duty cuts worth Rs 300bn which are likely to be followed by an interest rate cut by the Central Bank. This is a positive step by the government just before going into election and will help fire up the economy. For the day we are positive on the market.

# Earnings decline in FY10; UnderperformWe reset our dated estimates & Price Objective established prior to Sep 08 and the Axon acquisition. While an 8% dividend yield could limit downside, we rate the stock Underperform given forecast earnings decline next year, on near term cyclical pressures, restructuring in BPO and steep margin dilution led by Axon. We forecast flattish FY11 EPS, on expiry of tax holiday. Longer term, we are positive on the strategic steps to position itself in growth markets and tighten operations. Our PO of Rs100 is at 7x FY10E EPS, at 20% discount to TCS, on relative brand and risks.

# Near term earnings challengesWe forecast a modest decline in organic revs in FY09 & FY10 (Jun yr end) due to cyclical pressures, with an estimated 40-50% of revs, across enterprise solutions, R&D services & application development, being exposed to cuts in discretionary IT spending. BPO, another 10% of revs, is also in restructuring mode from voicework to transaction processing. We forecast over 500bps margin decline over FY08-10 (prior to intangibles writeoff & stock comp) due to dilution from Axon and BPO acquisitions, hedging losses, weak European currencies & pricing cuts.

# Longer term, promising strategic movesLonger term, we believe Axon significantly boosts HCLT’s position in SAP consulting, Europe, and new verticals like utilities. Also the US$1bn deal wins last quarter endorse a strengthening position in ‘run the business’ IT deals, though these will likely take 6 to 9 months to ramp, in our view. HCLT has also steadily improved bill-rates, utilization and lowered attrition over the last 3 years. Key upside risks: Faster than expected ramp of deals won and tax holiday extension,which could boost FY11 earnings by 15 to 20%.

* KG gas – prospective allocation — Recent press reports (Financial Express) have enlisted the gas-based urea units that would be allocated ~14mmscmd of initial KG gas. The press (Hindu) also indicates that commercial sales will commence by Apr at a rate of 15-20mmscmd and ramp up to 40 by Jul/Aug.

* Who gets what — As per the press reports, RCF has been allocated 3.0mmscmd of initial KG gas, followed by Kribhco and IFFCO (2.3 each), Nagarjuna Fert (1.5), Chambal (1.1), and others (see Figure 1 for breakdown).

* GAIL a beneficiary— Of the 13.7mmscmd of allocated fertilizer vols, 7.0 is expected to flow through GAIL’s core HBJ/DVPL/GREP pipelines and another 4.6 through its pipelines in AP, Mah. Coupled with 1.4 of vols allocated to Dabhol, our forecast of 17mmscmd of KG vols for GAIL in FY10E looks reasonable. Further, we assume just 2mmscmd flowing through HBJ and 15 through non-HBJ pipelines. The better-than-forecast mix of HBJ:non-HBJ vols provides cushion to our earnings, given HBJ tariffs are higher than non-HBJ.

Our visits to the Indian steel producers suggest that they are expecting a recovery in sales volumes, though prices remain weak. The government could raise import barriers further, protecting the industry from import competition. Demand-boosting measures, however, may take longer to execute.* Production recovering and prices stabilising

The Indian steelmakers have raised production volumes from the low levels of Nov-Dec and they expect sales volumes to improve qoq in the Jan quarter. However, sales volumes could still be down yoy. The volume recovery has so far not led to a price recovery, though prices have stabilised in February after a continuous decline over Sept 2008-Jan 2009. A strong price recovery looks very unlikely, as visibility remains low.

* Government actions may aid industry, but timing in questionThe government has announced several measures to protect the domestic steel industry, and we see the possibility of more, such as a further rise in import tariffs. Currently, however, we highlight the risk of delays, in decision-making and execution, due to the upcoming elections (probably in May/Jun 2009).

* Costs should decline, leading to EBITDA improvementsThe possibility of lower input costs is well known, particularly for imported coking-coal contracts, as new prices (which we forecast will be 60% lower) are to become effective from July. Efforts to renegotiate prices for remaining contract volumes for Jan-Jun 2009 are ongoing, and any success would be positive. This should boost margins for domestic steelmakers, which have remained profitable during the price downturn.